Some of us, me included, have used the "Dividend Reinvestment" option when going into such funds. (An option you should never use anyhow)
Dividend Reinvestment in Taxsaver funds is especially bad; you can never get your money out completely, since each investment is locked in for three years. Every year the fund announces a dividend, and typically they keep it quite high so that people invest. You have about five days after the announcement of dividend to buy and get that dividend. Why is this good? Because you can get a tax deduction on the whole amount invested (under Section 80C) and then get a part of your money back.
(Ex. SBI Magnum Taxsaver announced Rs. 11 dividend when its NAV was 55, a 20% yield. If you had about 90,000 available in 80C, you could have invested it in the fund and instantly got back 18,000, but got a tax benefit on the full 90,000).
Now why are dividend reinvestment options bad here? Because every year the dividend will get reinvested and locked in for yet another three years. You will never be able to completely withdraw from the fund, even if it underperforms like crazy.
You might think: Well, let them reinvest it every year, what difference does it make? It will contribute to some part of my section 80C investment anyhow, no?
Consider this: What happens if the government withdraws the 80C exemption, or decides that ELSS funds will not be part of 80C? Every year you will be reinvesting and locking in your money for three years further and getting no tax benefit.
Further consider what else comes under 80C. Housing loan principal for instance. So if you take a loan to buy a house, and if the loan is above Rs. 20 lakhs, you are sure to pay more than 1 lakh principal per year through your EMIs. So you don't need another 80C investment. But the dividend reinvestment gives you no option but to keep investing and locking in your money.
Also under 80C is your childrens' education fees. Given what schools charge today, that might well cover your 1 lakh limit by itself.
One thing you can do is attempt to speak to the fund house and change from re-investment to payout instead. Some fund houses are ok with this, but I can't say for sure if all of them will agree.
And going forward, either invest in the dividend payout option or in growth - never the reinvestment option.
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>I agree with you that gcompletely getting out may be difficult, however not impossible.
BUT your argument has a couple of flaws, IF the govt. removes ELSS from sec 80c then mate there would be no lock in period, the period is to give tax benefit
Also why invest in ELSS if you have other options has nothing to do with Dividend reinvestment or growth option
11.16.07 at 2:38 AM
>sumeet: If the govt. removes ELSS from 80C, the lock in period may not be removed – it is a feature of the fund scheme itself (i.e. the fund house and trustees will have to change the scheme fundamentals after such an event). While I hope that fund houses will act to remove the restriction, they probably will not be wont to, as now that scheme becomes exactly similar to their open ended diversified schemes.
What I’m talking about is a forced investment through a dividend reinvestment plan – meaning you have to put in the money there as “fresh” investment because of the way the plan is structured.
You might think this is equivalent to the growth plan but at least you can get out of the growth plan after three years.
11.16.07 at 4:53 AM
>Hi,
You were spot on regarding ELSS and equity funds. However in case of debt and other mutual funds not eligible for capital gains exemption, dividend reinvestment still makes sense, especially for those in higher tax brackets.
JACKSON DAVID
11.16.07 at 10:25 AM
>I thought debt/other mutual funds WERE eligible for long term cap gains taxes (which are lower than the corresponding taxes paid on any other type of income)
And even there dividend reinvestment makes no sense, as
a) the fund pays tax on the dividends which is higher than the long term cap gains tax of 10% – so what you reinvest will be whatever is left after the fund pays that tax.
b) you will always have at least some money in there less than a year (since dividend are likely to be declared every year) which is huge on cap gains (33% in the highest bracket)
Better to choose growth even in debt or money market funds.
I do not know any mutual funds not eligible for captial gains exemption (i.e. lower capital gains
In short, the dividend reinvestment option is useless today, only growth or payout makes sense.
11.16.07 at 10:58 AM
>Hi Deepak,
I appreciate your work on this blog as well as money yoga. Maybe you are fully engaged in equity and missed out this one on others. As per section 10(38) and rules thereunder only mutual fund units of equity oriented funds (which as per current definition means funds with >65% equity content) are eligible for long term capital gains exemption. All others are taxed at 10% on long term and 30% on short term gains.
Agreed, if you are staying for long term, definitely growth option is better in all cases.
If not, in debt or MIP funds, the NAV seldom moves up for the dividend option. In case of reinvestment you will get units at this NAV and usually there is no short term capital gains.
However, if you are into growth option and has to redeem before one year you will be taxed at 30% if you are in the highest tax bracket. Dividend tax(except in case of liquid funds), on the other hand is taxable at just around 15% for individuals.
JACKSON DAVID
11.17.07 at 11:49 AM
>Jackson: Ah, you have a point. If you are investing in debt funds for the short term (i.e. less than one year) you will end up saving on a dividend reinvestment option versus growth. I’ve written about that albeit in a different context.
But then let me play devil’s advocate. For a short term option one might as well use a dividend payout option as the differential in money between the two is very little. To show you how little – take an example: for a monthly dividend fund that gives out 3/4th of its monthly gain as dividend (and pays the div. tax on it), the highest differential betweena payout and reinvestment option is 0.06% after about 9 months. With 10 months and above, the dividend payout option actually scores better! (To give you an idea, the amount differential for a 1 crore investment is Rs. 6,000 for 12months minus one day, if you were to get 10% a year )
And then there is the paperwork for a dividend reinvestment (calculating average purchase price, dividing etc. and maintaining the record for the dividend stripping rule) Not really worth it in my opinion – take the dividend payout, and reinvest lumpsums when you feel like it.
Note that if you hold for even a day beyond 12 months you have suddenly lost a 5% advantage over the growth option. In the example earlier, for the 1 crore investment at say 10% the growth option makes 1.25 lakhs more than the div. reinvestment option.
Of course for a company having 1000 crores or something this might make sense entirely – and they might probably do well to take this advice. I think this option is useful to those having more than 5 crores on a short term basis, where the differential may actually make sense against the paperwork.
But this doesn’t apply to a) equity funds or b) debt funds you want to hold on to for more than a year.
11.17.07 at 8:40 PM
>Great thanks…It was simple and good.
Keep it up.
01.17.08 at 1:01 AM